Life Annuity or Retirement Withdrawal Portfolio
An annuity guarantees income but locks up capital: measure what you give up in liquidity and estate value.
In this article
Life annuity versus drawdown portfolio: the duel is a false one. The two formulas trade different risks for different freedoms, and the best answer is often to combine them. The annuity hands market and longevity risk to the insurer and guarantees income for life, but the capital is gone: no longer available in an emergency and no longer part of the estate, unless you pay for an option that reduces the income. The portfolio keeps liquidity, adjustable withdrawals and transferable capital, but it also keeps market risk, the sequence of returns first of all, and the risk of behaving badly. You calibrate the combination from your expenses: the gap between your essential needs and the income already guaranteed (public plans, employer pensions) sets what the annuity has to cover, and nothing more. The portfolio keeps the rest. This article prices both formulas on a typical case and shows how to calibrate a guaranteed floor under a flexible upper level.
Price what the annuity actually guarantees
A life annuity exchanges capital for income guaranteed for life. Start by getting real quotes rather than estimates: for the same capital, the monthly amount varies noticeably from one insurer to another. It depends on age, sex, interest rates at the time of purchase and the options you choose. Those options are costly. Inflation indexing, a minimum payment guarantee or a survivor benefit all reduce the starting amount, sometimes by a quarter. Quotes are hard to compare when the options differ.
Measure the liquidity given up
Capital paid to the insurer is no longer available. It can't cover a medical emergency, a renovation or help for a child, and it no longer forms part of the estate unless you take a guarantee option. That loss of flexibility is the real price of the guarantee, and you can measure it: what share of your wealth would be locked up? Converting all your savings to an annuity is rarely defensible. Converting part of it and keeping accessible capital for the unexpected is a very different decision. Part, not all.
Compare with a portfolio drawdown
The other route is to keep the capital invested and withdraw an amount each year. You keep liquidity, the option of leaving an inheritance and growth potential. In return you take on two risks the annuity removes: market risk, especially dangerous in the first years of drawdown, and the risk of outliving your plan. A prudent withdrawal rate, reviewed against actual returns, handles the first. Nothing in the portfolio really handles the second, and that is exactly the annuity's job.
Combine rather than choose
Practitioners most often end up with something that is neither one nor the other. Essential expenses (housing, food, utilities) are covered by income guaranteed for life: public pensions plus a life annuity bought to fill the gap. The portfolio then pays for discretionary spending: travel, leisure, help for the children. This structure removes the risk of lacking necessities while leaving flexibility for the rest. The calculation starts from the essential expense budget, which determines how much annuity to buy, not the other way around. Nothing forces you to buy it all at once either: buying in tranches over several years avoids depending on the rates of a single day. Quotes expire quickly, so each tranche is priced fresh.
Quebec scenario
With $480,000 in retirement savings, a former foreman in Alma hears two opposing pitches. The annuity representative promises the peace of a cheque for life, and his broker praises the flexibility of a drawdown portfolio. Instead of picking a side, he puts the two offers next to each other and measures them the same way. First the life annuity: $120,000 buys about $680 a month, guaranteed for life regardless of markets or how long he lives. In exchange, that capital is gone: it's no longer available in an emergency and no longer part of his estate, unless he pays for a guarantee by accepting a smaller income. Then the portfolio: the remaining $360,000 gives adjustable withdrawals, available at any time and transferable, but exposed to the market and to temptation. A bad sequence of returns early in retirement can eat into capital that no guarantee protects. He builds his grid from his expenses rather than from the products: $3,100 in essential needs per month, of which $2,400 is already covered by public plans and a small employer pension. The life annuity is asked to close the $700 gap, not a dollar more. The portfolio keeps the rest: projects, surprises, inheritance. Both salesmen leave with half the argument each, and he leaves with a guaranteed floor under a flexible upper level, the combination neither of them offered.
Checklist
- Price the essential monthly expenses
- Inventory the existing guaranteed income
- Calculate the essential gap to fill
- Give the annuity that precise mandate only
- Keep the rest in a flexible portfolio
- Compare annuities from several insurers
- Weigh the guarantee options and their cost
- Protect the portfolio from sequence risk
- Document the floor and the upper storey on file
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